The Oyu Tolgoi mine is due to start production next year and is expected to boost Mongolia's output by up to a quarter. Photo: Reuters

Mongolia's red-hot economy - one of the world's fastest-growing - has the chills due to a decline in investment interest from foreign investors.

The decline was brought on by a weak global economy and unfriendly policies launched by Mongolia's new populist government.

A World Bank economic report released late last month on the resource-rich nation sandwiched between Russia and China says Mongolia's economic growth fell from 18 per cent last year to 16.5 per cent in this year's first quarter and to 11 per cent in the second quarter.

Much of the growth was supported by construction of the Oyu Tolgoi copper and gold mine, one of the world's biggest. The mine is due to start commercial production next year and is expected to boost Mongolia's output by up to a quarter.

For the moment, the third quarter's outlook remains grim, as exports - over 90 per cent of which go to China, mostly in the form of coal and metals - fell 39 per cent year on year. That was the biggest fall since the height of the global financial crisis in mid-2009, but the World Bank expects full-year growth to be above 10 per cent.

The immediate change of fortunes came as growth in mainland steel production, the main driver for Mongolian coking coal, and iron ore exports, tumbled to low single-digits in the past few months, the lowest in three years. China's export-oriented manufacturing sector was hit by weak demand from developed nations struggling with sovereign debt woes, while domestic demand also slowed as Beijing's tight grip on lending to the overheated property sector remained firm.

The Mongolian Stock Exchange Top 20 Index has fallen 20 per cent since the nation's parliamentary election in late June, underperforming the MSCI World Index's 5.8 per cent gain.

Even so, he conceded that "there are a lot of questions and uncertainties that have been accumulating in regards to foreign direct investment".

One of the worries for foreign investors is the foreign direct investment law that was hastily passed by Mongolia's parliament in mid-May. The law subjects investments by foreign firms exceeding a certain size in some sectors to government approval. It was drafted by legislators alarmed by the bid from Aluminum Corp of China (Chalco) announced in early April for 60 per cent of Mongolian coal miner SouthGobi Resources.

The law subjects deals in the strategic industries of mining, finance and media and telecommunications of over US$75 million and those where foreign firms buy over 49 per cent of a Mongolian asset to government scrutiny. It was watered down from the original draft, but has nonetheless raised concerns.

James Passin, co-founder and manager of Firebird Mongolia Fund, which invests in stocks listed on the Mongolian exchange, said that since the law's passage, his firm had not made any new investment in strategic industries even though it raised hundreds of millions of US dollars for its managed funds.

"The law itself makes sense since the purpose is to regulate investment in strategic sectors, but some details are against the national strategic interest," Passin said. He cited provisions giving the government the power to revoke the licences of subsidiaries of firms in strategic industries if the parent firm's shareholding changed.

"This may not be the intent of the law," he said.

SouthGobi has fallen victim to such regulatory risk. After Chalco unveiled its takeover bid, the Mongolian government said it would suspend the firm's exploration and mining licences. The uncertainty saw its customers withhold coal orders, severely affecting sales. A few days after Chalco withdrew its bid in early September, the government told SouthGobi its licences were in good standing.

Following weak coal demand in China, SouthGobi last week posted a net loss of US$54.3 million in the six months to September 30, compared to a profit of US$123 million a year earlier. It plans to shed a third of its staff.

While the law mainly affects fresh investment into Mongolia, investors are closely watching the outcome of some Mongolian politicians' recent request to renegotiate the terms of an investment agreement for the Oyu Tolgoi copper-gold mine, co-owned by Australia's Rio Tinto and Canada's Turquoise Hill.

"Foreign direct investment is falling, according to government statistics, and investors are seeking further assurances that their interests will be protected," Oyu Tolgoi chief executive Cameron McRae said. "I believe Mongolia will stand by its promises."

Besides the harsher regulatory environment, foreign investors said investment in Mongolia was also held back by public relations battles between political factions, overly generous political handouts to win votes, worsening corruption, increasing bureaucracy, failing infrastructure, and lack of skilled workers.

After the Democratic Party won the parliamentary election in June this year, it formed a coalition with the smaller parties of Mongolian People's Revolutionary Party and the Mongolian National Democratic Party.

"With the [two smaller parties] now part of the ruling coalition, there is a risk the balance will tip too far away from the interest of foreign investors and scare them off," Rabobank research report said.

"There is a risk that foreign direct investment inflows will decline in the future."

According to Khan Bank chief executive Norihiko Kato, foreign direct investment into Mongolia grew from US$570 million in 2009 to US$1.63 billion in 2010 and US$3.8 billion last year. This year, it dropped from a high of US$380 million in May to US$300 million in June and US$100 million in July before rebounding to US$270 million in August.

Given Mongolia's reliance on foreign investment to fund its big trade and current account deficits, some analysts believe it is a matter of time before its government gets its act together to restore foreigners' investment confidence.

"I'm confident that despite the ups and downs, the direction of the economy is positive," said Christopher de Gruben, manager partner of real estate investment firm MAD Investment Solutions. "It is time for foreign investors and the Mongolian government to lay the first foundation of a relationship, initially by building a shaky ladder that will eventually develop into a solid bridge."

This article appeared in the South China Morning Post print edition as Mongolia's Midas touch loses some of its shine